The promise and perils of decentralised finance
The sceptics have plenty of fodder. The
earliest adopters of
bitcoin, the original cryptocurrency, used it to buy drugs,
while cyberhackers now demand their ransom in it. Hundreds
of millions of dollars of ether, another digital money, were stolen this year after hackers found a bug in some code. Many “believers” are in reality trying to get rich quick from the global mania that has seen the value of cryptoassets reach $2.2trn. Others
are freakishly devoted. The entrepreneur who announced in
June that El Salvador was adopting bitcoin as an official currency
sobbed on stage, claiming it would save the nation.
The crooks, fools and proselytisers are offputting. Nevertheless, the rise of an ecosystem of financial services, known as decentralised finance, or “DeFi”, deserves sober consideration (see Briefing). It has the potential to rewire how the financial system
works, with all the promise and perils that entails. The proliferation of innovation in DeFi is akin to the frenzy of invention in
the early phase of the web. At a time when people live ever more
of their lives online, the cryptorevolution could even remake
the architecture of the digital economy.
DeFi is one of three tech trends disrupting finance. Tech “platform” firms are muscling in on payments and banks. Governments are launching digital currencies, or govcoins. DeFi offers an alternative path which aims to spread power, not concentrate it. To understand how, start with blockchains, vast networks of computers that keep
an open, incorruptible common record and update it without the need for a central authority.
Bitcoin, the first big blockchain, created in
2009, is now a distraction. Instead, Ethereum, a
blockchain network created in 2015, upon
which most DeFi applications are built, is
reaching critical mass. Its developers view finance as a juicy target. Conventional banking requires a huge infrastructure to maintain trust between strangers, from clearing
houses and compliance to capital rules and courts. It is expensive and often captured by insiders: think of creditcard fees and
bankers’ yachts. By contrast, transactions on a blockchain are
trustworthy, cheap, transparent and quick—at least in theory.
Although the terminology is intimidating (fees are “gas”; the
main currency is ether, and title deeds over digital assets are
known as nfts), the basic activities taking place on DeFi are familiar. These include trading on exchanges and issuing loans
and taking deposits through selfexecuting agreements called
smart contracts. One yardstick of activity is the value of digital
instruments being used as collateral: from almost nothing in
early 2018 it has reached $90bn. Another is the value of transactions that Ethereum is verifying. In the second quarter this
reached $2.5trn, around the same sum as Visa processes and
equivalent to a sixth of the activity on Nasdaq, a stock exchange.
The dream of a lowfriction financial system is just the beginning. DeFi is spreading to more ambitious terrain. MetaMask, a
DeFi wallet with more than 10m users acts as a digital identity. To
enter a decentralised “metaverse”, a lookingglass world with
shops run by its users, you link your wallet to a cartoonish avatar
who roams around. These digital worlds will become the subject
of intensifying competition as more spending shifts online. Big
tech firms could impose huge taxes on these minieconomies:
imagine Apple’s App Store charging fees, or Facebook selling
your avatar’s intimate secrets. A better alternative might be decentralised networks that host applications and are run mutually by users. DeFi could provide payments and property rights.
Cryptoenthusiasts see a Utopia. But there is a long way to go
before DeFi is as reliable as, say, JPMorgan Chase or PayPal. Some
problems are prosaic. A common criticism is that blockchain
platforms do not scale easily and that the computers they harness consume wasteful amounts of electricity. But Ethereum is a
selfimprovement machine. When it is in high demand the fees
it charges for verification can climb, encouraging developers to
work on minimising the intensity with which they use it. There
will be new versions of Ethereum; other, better blockchains
could one day replace it.
Yet DeFi also raises questions about how a virtual economy
with its own norms interacts with the real world. One worry is
the lack of an external anchor of value. Cryptocurrencies are no
different from the dollar, in that they rely on people having a
shared expectation of their utility. However, conventional money is also backed by states with a monopoly on force and central
banks that are lenders of last resort. Without these, DeFi will be
vulnerable to panics. Contract enforcement
outside the virtual world is also a concern. A
blockchain contract may say you own a house
but only the police can enforce an eviction.
Governance and accountability in DeFiland
are rudimentary. A sequence of large irrevocable transactions that humans cannot override
could be dangerous, especially as coding errors
are inevitable. Moneylaundering has thrived
in the ungoverned grey zone of services lying between Ethereum
and the banking system. Despite the claims of decentralisation,
some programmers and app owners hold disproportionate sway
over the DeFi system. And a malign actor could even gain control
over a majority of the computers that run a blockchain.
Alice’s adventures in DeFi-land
Digital libertarians would prefer that DeFi remain autonomous—imperfect but pure. Yet to succeed it must integrate with
the conventional financial and legal systems, as Gary Gensler, a cryptoexpert who is America’s financial watchdog, has outlined
(see Buttonwood). Many DeFi applications are run by decentralised organisations which vote on some issues; these bodies
should become subject to laws and regulations. The Bank for International Settlements, a club for central banks, has suggested
that govcoins might be used in DeFi apps, providing stability.
Finance is entering a new era in which the three novel but
flawed visions of tech platforms, big government and DeFi will
compete and intermingle. Each embodies a technical architecture and an ideology about how the economy should be run. As
with the internet in the 1990s, no one knows where the revolution will end. But it stands to transform
how money works and,
as it does so, the entire digital world.